Five minutes with… Robert Arnott : Chairman, Founder of Research affiliates

Five minutes with… Robert Arnott : Chairman, Founder of Research affiliates …

Rob Arnott, the man who invented the RAFI indices, talks about the methodology and the secret of success for his fundamental indices.

How do the RAFI indices differ from traditional stock market indices?
With very few exceptions, the composition of most indices is based on the market capitalisation of the relevant stocks. Typically, the higher the stock market value of a share, the higher its index weighting. In the case of the RAFI indices, market capitalisation is a secondary factor. Instead, they use fundamental criteria to select stocks and determine their respective index weights.

In the past, the RAFI indices occasionally outperformed conventional stock market indices. Can you explain that?
We have severed the link between portfolio weights and over- or underweights. In cap-weighted indices, overvalued shares are systematically overweighted, while the weighting of undervalued shares is too low. At some point in time, the market will return to fair values. Then overvalued shares will tend to underperform, while undervalued shares will catch up. During this correction phase, traditional indices with their high weighting of overvalued shares will lag the RAFI indices – which assign relatively higher weights to undervalued shares and relatively lower weights to overvalued shares.

What caused the particularly strong lead of the RAFI indices in 2009?
The RAFI indices are reconstituted annually, the third Friday of March. In 2009, a particularly large number of undervalued shares were added to the RAFI indices. During the stock market rally that started soon after our index reweighting, these undervalued shares recorded disproportionate gains. But I would warn anyone from expecting this strong outperformance to continue endlessly into the future.

Will the RAFI indices drop back soon?
Model calculations for the past 40 years show that fundamental indices tend to outperform cap-weighted indices in about three out of any four periods. However, traditional indices will be difficult to beat during periods when growth stocks are in favour.

What are the key criteria on which the composition of the RAFI indices is based?
We use four straightforward and comprehensible measures of size: cash flow, sales, book value and dividends. All other key financials can be subsumed under these four ratios. However, our primary aim when defining these criteria was not to identify those criteria that had yielded the highest returns in the past, but to determine companies’ economic significance.

So the RAFI indices could be improved further?
We do have more ideas. But the critical success factor lies in the fact that the RAFI indices add value because positions in overvalued shares are systematically reduced through regular reweightings. We do not need any hidden key ratios to achieve that.

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Important information: This marketing document is directed at Professional Clients in Continental Europe only and is not for consumer use.

France, Germany, and Italy: This document is issued in France by Invesco Asset Management S.A., 18, rue de Londres, 75009 Paris. This document is issued in Germany by Invesco Asset Management Deutschland GmbH, An der Welle 5, 60322 -Frankfurt/M., regulated by Bundesanstalt für Finanzdienstleistungsaufsicht. This document is issued in Italy by Invesco Asset Management SA Sede Secondaria, Via Cordusio 2, 20123 Milano.
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PowerShares has been licensed by FTSE International Limited to use the name [«FTSE Research Affiliates Index]» «All copyright in the index values and constituent list vests in FTSE International Limited. PowerShares has obtained full licence from FTSE International Limited to use such copyright in the creation of this product
«FTSE®» is trade mark of the London Stock Exchange Plc and The Financial Times Limited and is used by FTSE International Limited under licence. «Research Affiliates» and «Fundamental Index» are trade marks of Research Affiliates.
The FTSE RAFI Italy 30 Index, the FTSE RAFI Europe Index, the FTSE RAFI Developed Europe Mid-Small Index, the FTSE RAFI US 1000 Index and the FTSE RAFI Developed 1000 Index are calculated by FTSE International Limited in conjunction with Research Affiliates LLC. FTSE International Limited or Research Affiliates LLC do not sponsor, endorse or promote these products.
The shares in the PowerShares FTSE RAFI Italy 30, PowerShares FTSE RAFI Europe, PowerShares FTSE RAFI Developed Europe Mid-Small, PowerShares FTSE RAFI US 1000 and PowerShares FTSE RAFI Developed 1000 Funds are not in any way sponsored, endorsed, sold or promoted by FTSE International Limited («FTSE») or by the London Stock Exchange Plc (the «Exchange») or by The Financial Times Limited («FT») or by Research Affiliates LLC («RA») and neither FTSE nor Exchange nor FT nor RA makes any warranty or representation whatsoever, expressly or impliedly, either as to the results to be obtained from the use of the FTSE RAFI Italy 30 Index, the FTSE RAFI Europe Index, the FTSE RAFI Developed Europe Mid-Small Index, the FTSE RAFI US 1000 Index and the FTSE RAFI Developed 1000 Index («Indices») and/or the figure at which the said Indices stand at any particular time on any particular day or otherwise. However, neither FTSE nor Exchange nor FT nor RA shall be liable (whether in negligence or otherwise) to any person for any error in the Indices and neither FTSE nor the Exchange nor FT nor RA shall be under any obligation to advise any person of any error therein.

Source: ETFWorld – PowerShares